What is cost of goods sold?
Cost of goods sold (COGS) refers to the direct costs involved in producing or purchasing the goods a business sells during a specific accounting period. It includes expenses such as raw materials, direct labour, and manufacturing overheads — but excludes indirect costs like administration, marketing, and distribution expenses, which are reported separately as operating expenses.
COGS is a key line item on the profit and loss (P&L) statement and is essential for calculating gross profit:
Sales revenue – COGS = Gross profit
The lower your COGS relative to revenue, the higher your gross profit margin — giving your business more capacity to cover operating expenses and generate net profit.
How to calculate COGS
The standard COGS formula is:
Beginning inventory + Purchases during the period – Ending inventory = COGS
For example, if a retail business starts the year with $2,000 in inventory, purchases $5,000 in stock during the year, and ends with $1,000 remaining, the COGS would be $6,000.
Components of COGS
- Direct materials: Raw materials or wholesale products used to create what’s sold
- Direct labour: Wages for workers directly involved in production
- Direct overheads: Costs tied directly to production, such as equipment maintenance and factory utilities
Inventory valuation methods
The method you choose to value inventory affects how COGS is calculated. Common methods include:
- FIFO (First In, First Out): Oldest inventory is sold first
- LIFO (Last In, First Out): Most recently acquired inventory is sold first
- Weighted Average Cost: Averages the cost of all inventory available for sale
Your accountant can advise on the most appropriate method for your business type and Australian tax obligations.